Insights
House bill would ban carried interest tax benefits for asset managers
TAX ALERT |
Authored by RSM US LLP
A new House bill would repeal most of the remaining tax benefits for carried interests held by managers of private equity funds, hedge funds, and certain other investment partnerships. The receipt of a profits interest would not be taxable but any income or gain later realized would be ordinary income and subject to self-employment tax. The bill would effectively remove the existing favorable rules for real estate funds, and for assets held for more than three years. This bill would generally not be retroactive, but other proposals may emerge as Congress considers this longstanding and controversial issue. Unfortunately, it is not possible to predict, at this point, what actions if any Congress will take in this area.
Carried interest and other profits interests
Under current law, fund managers holding a carried interest (a type of partnership profits interest, sometimes called ‘carry’) receive shares of the fund’s gain. That gain receives long term capital gain treatment if certain requirements, principally holding period requirements, are met. Section 1061, enacted in 2017, generally requires a three year holding period for gain with respect to carried interest to attain long term capital gain characterization. Long term capital gain is subjected to lower federal income tax rates than ordinary income.
Partners in a partnership generally are not taxed on their initial receipt of profits interests (such as carried interests), provided that they are received when liquidation of the partnership would result in no distribution with respect to the profits interests. The IRS endorsed this treatment in two Revenue Procedures, Rev. Proc. 2001-43 and Rev. Proc. 93-27. The partners are, of course, subject to tax if and when they actually receive a distributive share of partnership profits.
Outline of proposal
The latest legislative proposal to tax gain with respect to carried interests as ordinary income is quite thorough. The proposal would codify the generally favorable treatment of receipt of a profits interest as nontaxable. A carried interest’s share of partnership gain, however, would be targeted for ordinary income treatment. If enacted as proposed, the ordinary income recharacterization would in many cases apply to carried interest gain recognized after the enactment date.
In addition to making long-term capital gain treatment unavailable, the proposal aims to: (a) make the section 1202 capital gain exclusion on sale of qualified small business stock unavailable, (b) subject gain with respect to carried interests to self-employment tax, and (c) heighten tax penalties for certain tax understatements attributable to carried interests.
Proposed carried interest provisions
The proposal’s primary effect would be to recharacterize net capital gain (a defined term generally representing net long-term capital gain over net short-term capital loss) from an “investment services partnership interest” as ordinary income. Net capital losses would similarly be recharacterized as ordinary losses, but only to the extent that net capital gain was previously recharacterized as ordinary income—with the effect that a carried interest holder would not be able to obtain an overall benefit over the life of their carried interest from any loss recharacterization.
Also, in an override of general partnership tax principles, the proposal would require a carryholder that receives an in-kind distribution from a partnership with respect to that carried interest to immediately recognize any unrealized gain in the distributed property. This gain would be treated as ordinary income, regardless of the character of gain the property would otherwise generate if sold.
Since the proposal would largely require all capital gains with respect to carried interests to instead be treated as ordinary income, the existing three-year holding period rule of section 1061 would be largely mooted. The proposal would therefore repeal section 1061. Note that, although this proposal and section 1061 both address similar economic interests, the definition of a carried interest under section 1061 is not exactly the same as under the proposal.
Proposed effective date
The proposal’s income recharacterization rules generally would apply to taxable years ending on or after the date it is enacted. Therefore, these proposed rules could apply to taxable events which would have already occurred at the time of passage. However, the effect general net capital gain recharacterization rule (not the property distribution rule) would be limited to the lesser of the net capital gain for the entire year of enactment, or the net capital gain taking into account only gains and losses from the portion of the year after enactment. This could result in favorable treatment for pre-enactment gains, while retaining the ability of pre-enactment losses to offset post-enactment gains (reducing the amount recharacterized as ordinary income).
Miscellaneous provisions
In addition to providing for gain recharacterization, and sometimes acceleration, with respect to carried interests, the proposal would also subject all income with respect to covered carried interests to self-employment taxation, regardless of any other exception from the self-employment tax rules that might apply.
Special penalty provisions would also apply to certain attempts to avoid the rules provided for in the proposal. In particular, the typical 20% accuracy-related penalty would be raised to 40% of any underpayment related to such attempts. In addition, the generally applicable ‘reasonable cause’ exception from penalty application would be limited in a manner to that currently applied to corporate ‘tax shelter’ transactions.
Conclusion
The latest legislative proposal to tax gain with respect to carried interests seeks to apply ordinary income treatment to carried interest regardless of the holding period for the interest or the partnership’s gain property. While passage of this proposal is neither certain nor imminent, it may be worthwhile for fund managers together with their tax advisors to consider alternatives and options that may be preferable if the proposal passes.
Let's Talk!
Call us at +1 213.873.1700, email us at solutions@vasquezcpa.com or fill out the form below and we'll contact you to discuss your specific situation.
This article was written by Don Susswein, Stefan Gottschalk, Ben Wasmuth and originally appeared on 2021-02-18.
2020 RSM US LLP. All rights reserved.
https://rsmus.com/what-we-do/services/tax/federal-tax/partnership-tax-planning/house-bill-would-ban-carried-interest-tax-benefits-for-asset-man.html
The information contained herein is general in nature and based on authorities that are subject to change. RSM US LLP guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. RSM US LLP assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein. This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer.
RSM US Alliance provides its members with access to resources of RSM US LLP. RSM US Alliance member firms are separate and independent businesses and legal entities that are responsible for their own acts and omissions, and each is separate and independent from RSM US LLP. RSM US LLP is the U.S. member firm of RSM International, a global network of independent audit, tax, and consulting firms. Members of RSM US Alliance have access to RSM International resources through RSM US LLP but are not member firms of RSM International. Visit rsmus.com/about us for more information regarding RSM US LLP and RSM International. The RSM logo is used under license by RSM US LLP. RSM US Alliance products and services are proprietary to RSM US LLP.
Vasquez & Company LLP is a proud member of the RSM US Alliance, a premier affiliation of independent accounting and consulting firms in the United States. RSM US Alliance provides our firm with access to resources of RSM US LLP, the leading provider of audit, tax and consulting services focused on the middle market. RSM US LLP is a licensed CPA firm and the U.S. member of RSM International, a global network of independent audit, tax and consulting firms with more than 43,000 people in over 120 countries.
Our membership in RSM US Alliance has elevated our capabilities in the marketplace, helping to differentiate our firm from the competition while allowing us to maintain our independence and entrepreneurial culture. We have access to a valuable peer network of like-sized firms as well as a broad range of tools, expertise and technical resources.
For more information on how Vasquez & Company LLP can assist you, please call +1 213.873.1700.
Subscribe to receive important updates from our Insights and Resources.